Worried About Aflac's Japan Risks? Here's the Silver Lining

Aflac has the cash flow to support its valuation even if the yen weakens further while it has significant potential upside if the exchange rate improves.

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Whenever an industry leader trades at a cheap valuation it should draw the attention of investors, and that's exactly the situation with Aflac (NYSE:AFL). Concerns over currency weakness in Japan, where Aflac derives 75% of its revenue, have kept the stock price down. However, these concerns are overstated. Aflac has the cash flow to support its valuation even if the yen weakens further while it has significant potential upside if the exchange rate improves. Changes from the Affordable Care Act in the US also present Aflac with significant opportunity.

The Top Name in Health and Life Insurance

I've written bullish articles on property and casualty insurers like The Chubb Corporation(NYSE:CB) and Aspen Insurance Holdings(NYSE:AHL) recently. While I do have high expectations for these stocks, that sector carries more inherent risk as a massive natural disaster could hit any time and significantly increase their costs. There is a little more volatility in P&C insurers' business model than that of health and life insurers.

Health and life insurers enjoy significantly more stable costs over time. Aflac's history attests to the stability of its industry. Over the past 10 years, AFL has grown after-tax profit (NOPAT) by 15% compounded annually. In only two out of those 10 years did Aflac's NOPAT decline. This consistent growth has helped AFL to earn a top-quintile return on invested capital (ROIC) of 16%. Figure 1 tracks Aflac's NOPAT for the past 15 years.

Figure 1: Steady Growth in Net Operating Profit After Tax (NOPAT)

Sources: New Constructs, LLC and company filings.

Aflac's 16% ROIC is top amongst the 18 health and life insurers that my firm covers, while its 13% NOPAT margin ranks third. Combine that with its impressive brand recognition (the ubiquitous duck), and it's clear that Aflac is one of the strongest companies in its industry.

Japanese Business Is Growing Rapidly

At first glance, the results from Aflac Japan for 2013 look bad. Revenues declined by 12% and reported operating earnings declined by 7%. However, these declines were entirely due to weakness in the Japanese yen. The average yen/dollar exchange rate was 22% higher in 2013 compared to 2012.

Figure 2 is a table from Aflac's 2013 10-K that shows how Aflac Japan actually grew significantly in 2013 if one discounts the effect of the weak yen.

Figure 2: Yen Vs. Dollar Results -- Percentage Changes

Sources: New Constructs, LLC and company filings.

It's important to note that most of Aflac Japan's profits are not converted into dollars. Last year, only $771 million (8% of operating cash flow) was repatriated from Aflac Japan to Aflac US. Most of AFL's yen holdings are reinvested back into the business, so the exchange rate fluctuation does not have that large an effect on their operations.

The right side of figure 2, which strips away the impact of exchange rates, shows that Aflac Japan is growing at a healthy rate. I'm not a currency expert, and I don't pretend to know what the yen will do against the dollar in the near future. However, AFL has a strong enough business to withstand further weakening of the yen, and if the yen strengthens, earnings are going to experience a major surge.

Assurant beat revenue and earnings estimates handily, and I would expect AFL to do the same when it reports on April 29. Especially given AFL's large share buyback authorization, I would expect the company to beat on EPS.

Cheap Valuation Means Low Risk

Even if Aflac doesn't beat expectations this quarter, the company remains a solid long-term bet. Fears over the yen have kept the valuation down below reasonable levels. At its current valuation of ~$62/share, AFL has a price-to-economic book value of 1, which implies that the company will never grow profits again. Those are very low expectations for a company that reported 15% compounded annually over the past decade.

With even modest growth, AFL has significant potential upside. If we give Aflac credit for NOPAT growth of just 6% compounded annually for 10 years, the stock has a fair value of ~$81/share. If the yen ends up strengthening against the dollar, profits could grow much more rapidly and AFL could have an even higher potential upside.

In this high-risk environment, AFL is a safe choice. Its cheap valuation and large buyback authorization should limit the downside, while solid growth gives it a large potential upside.

Mr. Trainer is a Wall Street veteran and corporate finance expert. He specializes in reversing accounting distortions on the underlying economics of business performance and stock valuation. He is author of Modern Tools for Valuation (Wiley Finance 2010).